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THE MELTDOWN Over the last few weeks we’ve experienced extreme volatility, and fear, in the financial markets. The event itself wasn’t unexpected around here. After all, we’re on record as expecting to see the Greater Depression materialize in the years to come. Maybe even starting now. But just because something is inevitable doesn’t mean it’s imminent. Some of you may be asking "OK, Casey, but what makes you think that a depression is inevitable – forget about imminent?" A proper answer to that would take a couple of chapters, and this isn’t the forum for that. Besides, I’ve done that in my book Crisis Investing for the Rest of the 90’s. Unfortunately, the book has been off the shelves for some years. If you have a copy, go over it, and see if the reasoning seems sound. In essence, however, an economic depression is a period of time when most people’s standard of living drops significantly. More exactly, it’s a period of time when distortions and misallocations of capital – caused by government intervention in the economy, particularly by currency inflation – are liquidated. Inflation sends false signals to both businessmen and consumers; it makes consumers think they’re richer than they really are, so they spend more. Businessmen gear up to meet this artificially created demand, by hiring more workers and building more facilities. Currency inflation, in its early stages, gives the appearance of prosperity. It also tends to lower interest rates simply because interest is the price of money, and when you expand the supply of anything, its price tends to fall; so everybody tends to save less and borrow more. Later, however, rates rise, because people won’t lend without compensation for the currency’s depreciation. The process causes a phenomenon called the business cycle. A phony boom can cause a very real depression. The long boom we’ve had since the bottom of the last cycle in 1982 – a time that was characterized by high unemployment, lots of bankruptcies, high interest rates, and a low stock market – has lasted 25 years. It could have ended badly a number of times along the way, such as 1987, 1993, or 2000. Each time the government propped the house of cards up higher by injecting more currency into the system. It’s analogous to someone driving a high-performance car on a mountain road with a stuck throttle. The driver can mash on the brakes, slowing it from 50 to 30. The car charges to 80, but this time the fading brakes can only bring it down to 60. After a couple of cycles, it’s going 140. And Ben Bernanke is no Michael Schumacher. Perhaps he can navigate the road. But the chances are better, at this point, that the economy will go off a cliff. So, if we’re going to have a depression, what should you do about it? Our advice here has always emphasized owning a lot of gold. That’s because it’s the only financial asset that’s not somebody else’s liability. That’s important whether the depression is deflationary or inflationary in nature. Deflationary depressions are characterized by lots of bankruptcies and defaults; the only assets you can count on are those in your own possession, like cash or gold. Currency becomes more valuable because so much is wiped out in defaults. But gold is the ultimate form of cash. Inflationary depressions, however, wipe out the currency itself, which loses value rapidly, because the government creates so much more. Gold profits from this process. Is this the start of something big and nasty? It’s impossible to say. But the slap the markets have administered upside the back of everyone’s head should alert them to the possibility. You want lots of gold. Limited debt. International diversification. And some situations – like our recommended gold stocks – that present some real speculative upside. The ultimate cause of all the problems we’re facing is government, with its taxes, regulations, inflation. And wars, pogroms, confiscations, persecutions, and myriad other stupidities. But most people are more concerned today about the proximate cause of the recent unpleasantness. The Proximate Cause The genesis of the current crisis is subprime mortgages. For well over a decade, lenders have been making mortgage loans available to literally anybody with a pulse who wanted to own a house. Several times, in the mid-‘90s, I expressed astonishment at the fact lenders were loaning over 100% of the appraised value of a house. Even back then, it seemed that was the top of the housing bubble. But what do you know? It hadn’t even turned on the turbos… just going to show how hard it is sometimes to pick an actual top. This leads to one of the more interesting distortions arising from a really big credit-driven boom. You know the old saying: If you owe a banker a little money and can’t pay, you’re in trouble. But if you owe a lot of money, he’s in trouble. That’s exactly what’s happened here. All those new homeowners are already having trouble paying their mortgages. As rates go up, their ranks will swell since they’re almost all on floating-rate mortgages. Higher rates and more distress sales will take housing prices lower. Which, in turn, will encourage more people to leave their keys in the mailbox and walk away. On the other side of the trade are all the funds and institutions that bought the paper. They’ll eventually recover some percentage of their money, after the houses in question have gone into foreclosure and are taken over by new owners. The ones who will really be hurt are the hedge funds, which have become so popular in recent years. Hedge funds are investment pools, available only to sophisticated investors, which are essentially unregulated and can invest in anything, long or short. And, most important, in any amount of debt. In fact, what many appear to have been doing in recent years is borrowing money cheaply (perhaps paying 1% in yen), and then using the proceeds to buy high-yielding paper (like subprime mortgages yielding perhaps 8%). A million dollars of capital invested at 8% would impress nobody; a million dollars, plus another 9 million borrowed at 1%, however, would yield 64%. This was essentially what Long Term Capital Management was doing when it blew up in 1998. What’s happening today is a repetition of that misadventure, except on a much larger scale: it is said that some large percentage of the estimated 9,000 hedge funds in existence now control over a trillion dollars in debt. The future of those funds is very much in doubt. The government will probably come up with some moronic and counterproductive scheme to keep people who can’t afford their houses – and should be renting, which is a much better bargain today – in them. That will also serve to save the investors’ bacon. What it will also do is add to already massive burden on taxpayers. And it will acutely accelerate the destruction of the currency. As an aside, it will also give the SEC an entrée to regulate hedge funds, which will serve no useful purpose. What you’re really asking yourself, however, in view of the specialty of our flagship publication, the International Speculator, is: "What about our mining stocks?" Mining Stocks These, as you well know, are probably the most volatile securities on the planet. And you’ve just had a demonstration of how volatility can go both ways. Many have gone up by a factor of 10, or more, since the current bull market started in 2000. But on August 16th alone, the average stock went down about 10%. I’d say most stocks are off 40% from their previous highs. Many are asking themselves if the bull market is over. I’d say, almost certainly not. This is for several reasons: 1. We’re still in the Wall of Worry stage of the market. The Stealth stage ended in 2003, and the Mania stage hasn’t yet begun. The bulls and the bears are still fighting. Retrenchments like this happen. Bull markets naturally try to take as few investors along as possible; it simply wouldn’t do if everybody could make a living in the market. Who’d do the real work? But the market will continue to climb the Wall of Worry in my view. And we will have a Mania. 2. The public is still out of the gold market. I promise you that every market top I’ve witnessed in my life was accompanied by cocktail party chatter about the asset class in question. I have yet to have any indication the public has a clue that gold and other resources even exist. If this is a market top, it’s unique. 3. Extraneous factors, not fundamentals, caused the sell-off. In other words, gold went down simply because there was a bid for it, and sellers needed dollars to meet their obligations. All the other metals were in the same position. Hedge funds appear to have owned a lot of metals, simply because they offer a lot of leverage. And the stocks, which are always illiquid, were showing their usual leverage. 4. Governments all over the world are pumping hundreds of billions into the system. They’re doing that to ward off a credit collapse, and will almost certainly succeed. But all that extra purchasing media means higher inflation and brings us closer to the day that the foreign holders of $6 trillion will step up to the cashier and ask for their money back. The attention of the markets will soon shift to gold. My guess, therefore, is that the ugliness for the mining stocks won’t last long. I don’t have any prediction about exactly when the golds will come back. But I think that by year-end, they’ll be heading strongly back toward new highs. I will say this: you want gold stocks, not copper, nickel, lead, zinc, or even silver. Gold is the cheapest asset out there. Uranium remains my second favorite. We saw the meltdown of the subprime market coming. And correctly anticipated the government’s response. But we didn’t, I think, adequately clock how ugly it would be for the juniors. Why not? The fact is that once you sell, you tend not to buy back in. And trading is a sucker’s game; the odds are greatly tilted against you by the bid/ask spreads, commissions and, most importantly, your own emotions. So we only like to sell when we think a particular company is going in the wrong direction. Recall the recent tech boom. There were numerous brutal sell-offs on the way to the ultimate top in March 2000. We’ll have other sell-offs in this market as well on the way to the top. Rest assured, we’re anxious to give an all-out sell on all these resource stocks. At that point, we hope to have found a market sector that’s as cheap as they were back in 2000. But that’s not yet, and probably not for a couple of years. Hang tough. Buy more of the best of the best.
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